Chapter 13 Exchange Rates and the Foreign Exchange Market: An Asset Approach

Chapter 13Exchange Rates and the Foreign Exchange Market:

An Asset Approach

Slide 13-2

Introduction

Exchange rates are important because they enable us to translate different counties’ prices into comparable terms.

Exchange rates are determined in the same way as other asset prices.

The general goal of this chapter is to show: • How exchange rates are determined

• The role of exchange rates in international trade

Slide 13-3

Exchange Rates and International Transactions The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the Foreign Exchange Market Interest Rates, Expectations, and Equilibrium

Chapter Organization

Slide 13-4

Exchange Rates and International Transactions

An exchange rate can be quoted in two ways:• Direct

– The price of the foreign currency in terms of dollars

• Indirect– The price of dollars in terms of the foreign currency

Slide 13-5

Domestic and Foreign Prices• If we know the exchange rate between two

countries’ currencies, we can compute the price of one country’s exports in terms of the other country’s money.

– Example: The dollar price of a £50 sweater with a dollar exchange rate of $1.50 per pound is (1.50 $/£) x (£50) = $75.


Slide 13-6

• Two types of changes in exchange rates:– Depreciation of home country’s currency– Appreciation of home country’s currency


Slide 13-7

Exchange Rates and Relative Prices• Appreciation of a country’s currency:

– Raises the relative price of its exports– Lowers the relative price of its imports

• Depreciation of a country’s currency:– Lowers the relative price of its exports– Raises the relative price of its imports


Slide 13-8

The Foreign Exchange Market

The Actors• The major participants in the foreign exchange

market are:– Commercial banks– International corporations– Nonbank financial institutions– Central banks

Slide 13-9

• Interbank trading– Foreign currency trading among banks– It accounts for most of the activity in the foreign

exchange market.


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Characteristics of the Market• The worldwide volume of foreign exchange

trading is enormous, and it has ballooned in recent years.

• New technologies, are used among the major foreign exchange trading centers

• The integration of financial centers implies that there can be no significant arbitrage.


Slide 13-11

• Vehicle currency– A currency that is widely used to denominate

international contracts made by parties who do not reside in the country that issues the vehicle currency.

– Example: In 2001, around 90% of transactions between banks involved exchanges of foreign currencies for U.S. dollars.


Slide 13-12

Spot Rates and Forward Rates• Spot exchange rates

– Apply to exchange currencies “on the spot”

• Forward exchange rates– Apply to exchange currencies on some future date

at a prenegotiated exchange rate

• Forward and spot exchange rates, while not necessarily equal, do move closely together.


Slide 13-13

Figure 13-1: Dollar/Pound Spot and Forward Exchange Rates, 1981-2001


Slide 13-14

Foreign Exchange Swaps• Spot sales of a currency combined with a forward

repurchase of the currency.

• They make up a significant proportion of all foreign exchange trading.


Slide 13-15

Futures and Options• Futures contract

– The buyer buys a promise that a specified amount of foreign currency will be delivered on a specified date in the future.

• Foreign exchange option – The owner has the right to buy or sell a specified

amount of foreign currency at a specified price at any time up to a specified expiration date.

But the owner is under no obligation to exercise his right


Slide 13-16

Exchange Rates and Asset Returns

• If an investor in US has some idle money , how to decide whether to buy a euro or a dollar deposit ?

• Rules : compare the expected returns of each asset

The Demand for Foreign Currency Assets

Slide 13-17

Example

Assumption:

R$ = 10% R€=5% E$/€ = 1.1 Ee$/€ = 1.05

the dollar rate of return on dollar deposit: 10%

the dollar rate of return on EURO deposit:


11%1.1

1.11.223

Slide 13-18

A Simple Rule• Calculate the dollar return on a euro deposit.

• Compare the dollar return with the dollar return on a euro deposit


Slide 13-19

If:

R$ = interest rate on one-year dollar deposits

R€ = today’s interest rate on one-year euro deposits

E$/€ = today’s dollar/euro exchange rate

Ee$/€ = dollar/euro exchange rate

(expected to prevail a year from today


Slide 13-20

Dollar expected return R$

The expected dollar return on Eruo :

R€ + (Ee$/€ -E$/€ )/E$/€

Difference in the expected rate of return

R$ - [R€ + (Ee$/ € - E$/€ )/E$/€ ]

= R$ - R€ - (Ee$/€ -E$/€ )/E$/€

Slide 13-21

• When the difference in Equation is positive, dollar deposits yield the higher expected rate of return. When it is negative, euro deposits yield the higher expected rate of return.


Slide 13-22


Slide 13-23

Return, Risk, and Liquidity in the Foreign Exchange Market• The demand for foreign currency assets depends

not only on returns but on risk and liquidity.

• We ignore the risk and liquidity motives for holding foreign currencies.


Slide 13-24

Equilibrium in the Foreign Exchange Market

Interest Parity: The Basic Equilibrium Condition• The foreign exchange market is in equilibrium

when deposits of all currencies offer the same expected rate of return.

Slide 13-25

• Interest parity condition

–The expected returns on deposits of any two currencies are equal when measured in the same currency.

–Potential holders of foreign currency deposits view them all as equally desirable assets.

R$ = R€ + (Ee$/€ - E$/€)/E$/€

Slide 13-26

How Changes in the Current Exchange Rate Affect Expected Returns• Depreciation (Appreciation) of a country’s

currency today lowers (raises) the expected domestic currency return on foreign currency deposits.


Slide 13-27

Table 13-4: Today’s Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits When Ee

$/€ = $1.05 per Euro


Slide 13-28

Figure 13-3: The Relation Between the Current Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits

Expected dollar return on euro deposits, R€ + (Ee

$/€ - E$/€)/(E$/€)

Today’s dollar/euro exchange rate, E$/€

1.02

1.03

1.05

1.07

0.031 0.050 0.069 0.079 0.100

1.00


Slide 13-29

The Equilibrium Exchange Rate• Exchange rates always adjust to maintain interest

parity.

• Assume the following are given:

R$, R€, Ee$/€,


Slide 13-30

Figure 13-4: Determination of the Equilibrium Dollar/Euro Exchange Rate

R$

Return on dollar deposits

Rates of return(in dollar terms)

Exchange rate, E$/€

E2$/€ 2

1E1$/€

E3$/€

3

Expected return on euro deposits


Slide 13-31

The Effect of Changing Interest Rates on the Current Exchange Rate

– A rise in dollar interest rates causes the dollar to appreciate against the euro.

– A rise in euro interest rates causes the dollar to depreciate against the euro.

Interest Rates, Expectations, and Equilibrium

Slide 13-32

Dollar return

R2$R1

$

Figure 13-5: Effect of a Rise in the Dollar Interest Rate



2E2$/€

1'1E1$/€

Expected euro return


Slide 13-33

Dollar return

R$

Figure 13-6: Effect of a Rise in the Euro Interest Rate



1E1$/€

2E2$/€

Rise in euro interest rate

Expected euro return


Slide 13-34

The Effect of Changing Expectations on the Current Exchange Rate• A rise(fall) in the expected future exchange rate

causes a rise (fall)in the current exchange rate.


Slide 13-35

Summary

Exchange rates are determined in the foreign exchange market.

The exchange rate is most appropriately thought of as being an asset price itself.

The returns on deposits traded in the foreign exchange market depend on interest rates and expected exchange rate changes.

Slide 13-36

Summary Equilibrium in the foreign exchange market

requires interest parity. A rise in dollar (euro) interest rates causes the

dollar to appreciate (depreciate) against the euro.

Expected appreciation(appreciation) of the curreny will cause current appreciation (depreciation).

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Chapter 13 Exchange Rates and the Foreign Exchange Market: An Asset Approach